Juice Company Valuation Jenkins

Development Discussion Papers

Market Competitiveness, Risk and Economic Return:

The case of the Limassol Juice Company

Andreas P. Andreou

Glenn P. Jenkins

Savvakis C. Savvides

Development Discussion Paper No. 330

July 1991

Harvard Institute

for International Development

HARVARD UNIVERSITY

Copyright 1991 Andreou, Jenkins, Savvides

and President and Fellows of Harvard College

ABSTRACT*

This paper evaluates the strategic options available to a juicedrink manufacturing company in Cyprus who is facing seriousproblems of survival in an aggressive and rapidly changing marketenvironment. Following an initial screening of possibleinvestments, based on a qualitative evaluation of the market, thetwo most promising strategies are formulated and appraised forfinancial and economic viability. The financial appraisal analyses the projected cash flows fromthe owner's and total investment perspectives. The economicappraisal is then presented along with the workings for thederivation of the economic discount rate, foreign exchangepremium and several economic conversion factors for Cyprus. Thedistributive analysis identifies the externalities generated bythe two alternative strategies and allocates them to the variousaffected groups in the economy. The investment decision isfurther enhanced by the application of sensitivity and riskanalysis which compares the risk profiles of the two strategies.

The authors like to thank the Harvard Institute for InternationalDevelopment and the Cyprus Development Bank for co-sponsoring theHIID case study series. They also like to give special thanks toDinos Costa of the Cyprus Development Bank for his valuablecomments and assistance in the derivation of the economicconversion factors used in this study.

---------------------------------------------------------------*Andreas P. Andreou is a Senior Analyst, Head of theCorporate Management Unit at the Cyprus Development Bank.

* Glenn P. Jenkins is an Institute Fellow of the Harvardinstitute for International Development and Director of theProgram of Investment Appraisal and Management and theInternational Tax Program at Harvard University.

* Savvakis C. Savvides is a Senior Analyst, Head of theMarketing Unit at the Cyprus Development Bank and ResearchFellow of the International Tax Program at HarvardUniversity.

1 The name of the company and the timing of the project havebeen changed in response to the wishes of the company concernedto remain anonymous. The main parameters of the project have,however, remained basically unchanged.

3

I. INTRODUCTION

The Limassol Juice Company (LJC)1 has been the leading producer

of non-carbonated juice drinks in Cyprus during the sixties and

early seventies. The company has in the course of the past ten

years lost its leadership to two other suppliers who adopted

modern management methods and were quick in switching from the

traditional tin canning of juice drinks to aseptic carton

packaging.

The present study reviews the causes for the changing fortunes of

the Limassol Juice company and examines its strategic position

and prospects within the changing market for juice drinks in

Cyprus. The strategic investment options of LJC are considered

within the spectrum of the competitive profiles of the major

market competitors and its own potential capabilities. Following

a qualitative screening of alternative marketing strategies the

analysis focuses on two investment scenarios. These mutually

exclusive projects involve substantially different investments

and are subject to varying risk/return profiles. The two projects

are quantitatively formulated and appraised for financial and

economic viability. Risk analysis further enhances the investment

decicion by extracting and comparing the different risk profiles

of the two alternative projects.

2 Sales of natural juices have more than doubled in the pastfour years. In the same period Limassol Juice Company's marketshare was reduced to a mere 5% of the market.

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II. THE MARKET FOR JUICE DRINKS

The market performance gap

The introduction of the newly packaged products and the

aggressive marketing efforts of the two main competing suppliers

caused a rapid expansion of the market while having a devastating

effect on the market share of the Limassol Juice Company2.

The two companies have capitalised on a sizeable market

performance gap which was brought about by the combined effect of

a growing market need for more natural/healthy refreshing drinks

and a capability shortfall by existing soft drink producers to

supply natural juice drinks in a convenient package with long

shelf-life all the year round.

The market need for natural juice refreshments has intensified in

the past ten years because of the fast growth in the standard of

living in Cyprus and the rapidly expanding tourist market. The

capability shortfall was basically the result of technological

limitations with respect to packaging (tin canning is expensive,

has low shelf life, affects the taste and quality of the juice,

and is rather inconvenient for the consumer to use).

Aseptic carton packaging offers distinct advantages to the

3 In terms of new products there was the introduction of anew breed of still light-juice products with the generaldescription of "fruit drinks". In this category, the marketwitnessed the successful launching of new brands which were verypopular with children.

5

supplier and important benefits to the consumer. The process of

production can be more automated and less costly while enabling a

more convenient packing, longer product life and cheaper price.

LJC's main competitors exploited the advantages made available by

the new technology to respond to the opportunity presented to

them by a real, unsatisfied need of a potentially substantial

market.

The relevant market aimed by these suppliers included practically

the whole family (but in particular the children) and the soft-

drinks consumption requirements of a fast expanding tourist

market. The main improvement in market performance came in the

field of packaging and price with only minor changes in actual

product3. The juice manufacturers were able to extend the juice

market through mainly penetrating the market for carbonated

drinks by attracting the "health and fitness" conscious

consumers.

The local and export market for juice drinks

Cyprus fruit juice suppliers cater both to the domestic and

export market. The export market is composed mainly of orders

from neighbouring Arab countries. It absorbs about 10% of the

4 The estimates are based on the expert opinion of themarketing manager of the company. The validity of theseassumptions was not verified through field work.

6

country's total production. Exports of juice are not considered

to be sustainable given the on-going development of local juice

packaging industries in the Middle East.

The domestic market has considerably grown since the introduction

of the aseptic carton package and presently accounts for about

90% of total industry sales. A market segmentation of the local

consumption of juices with an estimate of the importance of each

segment was prepared in order to facilitate the strategic

appraisal of the project4. The importance of the various places

of consumption vis-a-vis the type of consumer is as shown below:

Level of juice consumption

Place of consumption Adults Children Tourists Total

The home 40% 60% 50%Hotels & hotel apts. 5% 5% 90% 15%Schools 100% 10%Bars and Cafes 70% 30% 10%Events (Soccer, festivals) 70% 20% 10% 5%Restaurants 50% 10% 40% 5%Birthday parties 100% 3%The army 100% 2%

100%

7

Based on the above market segmentation the importance of each

consumer is calculated as shown in the chart below:

Market size

Given the current market size of 8,500 tons per year, the

expected continued increase in the local market and the declining

growth projections for exports, it is projected that the market

size in terms of volume (in tons) will be as follows:

Years 0 1 2 3 4 ... 10 -----------------------------------------------Local market 7500 8313 8788 9126 9388 ... 10312Export market 1000 928 885 855 832 ... 750 -----------------------------------------------Total market 8500 9241 9673 9981 10220 ... 11062 ===============================================

5 The profiles were constructed based on market observationand interviews with a sample of consumers.

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III. THE LIMASSOL JUICE COMPANY

Background

Unlike its competitors LJC was very slow to react to changes in

its market environment. The company was almost totally inward

looking, characterised by a strong production orientation. LJC

perceived its business mission to be tin canning rather than the

supply of juice products to serve the needs of its customers. The

almost total lack of a marketing orientation made the company

unable to identify and respond to opportunities and threats in

its market environment. As a result LJC was operating under a

near obsolete distribution system that covered only partially the

local market. In addition, mainly due to the effects of its

persistence in using "tin canning", the company's products were

highly priced and had a relatively shorter shelf life than other

competing products packaged in aseptic carton.

Competitive analysis

The following competitive profiles5 of the two competitors were

used to identify the strategic possibilities for LJC to stage a

come-back in the juice market in Cyprus:

9

Competitor profiles of juice suppliers

+)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))),* ** !! Competitor A = Market share 35% ** ## Competitor B = Market share 60% ** LJC = Market share 5% ** ** ** Marketing effectiveness ** 0----------------------------------100%** ** Product - quality !!!!!!!!!!!!!!!! ** ################ ** ** ** - variety !!!!!!!!!!!!!!!!!!! ** ###################### ** ** ** - packaging !!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!! ** ################################# ** ** ** Price !!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!! ** ################################# ** ** ** Distribution !!!!!!!!!!!!!!! ** ############################# ** ** ** Promotion !!!!!!!!!!!!!!!!!! ** ####################### ** ** *.))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))-

The importance of having an efficient distribution system is

highlighted in the above profiles. Competitor A, although first

in adopting the new package (which enabled him to also offer a

more convenient product at a better price), found himself

trailing behind competitor B who entered the market about a year

later but with a much more efficient distribution system.

6 In spite the availability of a variety of other fruitjuice drinks (pineapple, tomato, apple etc.) since theintroduction of aseptic carton packaging about 3 years ago, salesof orange and grapefruit juice drinks still account for more than

10

The market environment

A review of recent market trends, changes in life styles and

recent technological developments with regard to the marketing

and consumption of juices and related products in the Cyprus

environment suggests the following opportunities and threats that

currently face LJC.

Opportunities

The market for juice drinks has been expanding because existing

juice drinks were made cheaper and more convenient to use. A

substantial market opportunity still remains unexplored which can

be exploited by LJC through product improvement.

Product improvement can take the form of extending the "variety"

of juices (e.g. mixed fruits, grape juice, etc.) and/or the

enhancing of "quality" of existing product lines (primarily

orange and grapefruit). Given its capabilities (see below) LJC is

in a rather good position for developing and marketing a

significantly better orange and grapefruit juice. Extending the

product line is not likely to attain a sustainable competitive

advantage for LJC for the following reasons:

- the juice market demand is predominantly for orange and

grapefruit flavours6.

90% of all total market sales.

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- other suppliers can easily match the introduction of

new juice flavours.

Threats

The biggest threat facing LJC and other similar canning factories

in Cyprus that persist in manufacturing and trading their juice

products in tins is that they will loose their market

competitiveness. Tin has become too expensive to be a viable

alternative as packing material for juices. The cost of tin alone

can be up to five times higher than carton. This causes the

prices of tinned canned juice to be as much as two to three times

higher than carton or plastic packaged juice drinks. As a result,

LJC is currently forced to work at very low profit margins in

order to have any impact at all on the market. This, indeed, is

the main reason why at present its market share does not exceed

5% of total sales of natural juices and fruit drinks. The

prospects facing LJC if things remain unchanged are therefore

extremely poor.

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Corporate capabilities

An examination of LJC's market image, its distribution and its

physical and human resources indicates the following strengths

and weaknesses of the company with regard to its juice and drinks

business.

Strengths

1. LJC still maintains a relatively good name as manufacturers of

juice drinks.

2. LJC has good expertise and know-how in the development and

production of juice products.

3. The company owns and maintains in good working order superior

machinery for the extraction and concentration of juices.

4. The company has excellent storage facilities and ample space

for factory extensions.

Weaknesses

1. LJC distribution system is very bad.

2. LJC has rather poor advertising and mass market selling

capabilities.

3. LJC has a deficient organisational structure.

7 Marketing effort refers to the distribution, promotion andpricing strategies adopted. An aggressive marketing effortstrategy would imply a relatively high budget for these threeelements of the marketing mix. A high marketing budget isconsidered justifiable only in strategy D ("offensive" strategy).

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IV. MARKETING STRATEGY DEVELOPMENT

In considering its options with regard to product, package and

marketing effort7 LJC is faced with four distinct marketing

strategies that it could follow as illustrated in the following

two-by-two matrix table :-

SAME NEWPACKAGE PACKAGE__________________

| | |SAME | A | C |PRODUCT | | | |________|_________| | | |NEW | B | D |PRODUCT | | | |________|_________|

A. Same product - Same package

This is the most grim option facing the firm. To do nothing and

to continue as at present means that LJC will in effect have to

exit the market for juices. Market prospects are poor and profit

margins extremely thin due to high costs of tin as raw material

for packing juice products. This option is therefore dismissed as

not potentially viable.

14

B. New product - Same package

A market for new and better pure juices potentially exists, but

however, costs of production are prohibitive due to the high

price for tin cans which also are less popular than the less

expensive aseptic carton packaging. An improved new product

packaged in tin cans therefore, although a better alternative

than strategy A, will be too expensive and will lack the end-user

convenience needed to make it successful in the market. This

option is therefore also screened out as a potentially a non-

viable one.

C. Same product - New package

This is the current market status of the two main competitors in

the juice and fruit drinks market. If LJC opts for this solution,

it will improve its production costs and will be at parity with

the main market leaders as far as product and price are

concerned. Although third in the market, such a situation can

under certain assumptions present LJC with an opportunity for

good profits and an adequate return and possibly lower risk. This

option is therefore considered as possibly a viable option and is

appraised as the "Me-too" scenario below.

D. New product - New package

A new product - new package strategy may offer the best prospects

for high return and company growth.

15

Under this scenario LJC will have to produce a complete product

line supplying all juice types marketed by its competitors. The

main competitive thrust of the "offensive" strategy will however

be derived from marketing a better orange juice.

Existing juice drinks seem to loose out on taste and appearance.

The pasteurisation and concentration of juice for storage and

subsequent deconcentration processes are believed to be the main

causes for such product short-comings. Through various

discussions mainly with the management of LJC the following

partial solutions to this problem were put forward:

1. Although slightly more costly, lower concentration of

juice can improve the end consumer product's quality.

2. The extraction of fruit fibers before concentration and

its subsequent injection back after deconcentration can

have a positive effect on taste.

3. Adding some freshly squeezed (pasteurised) juice to the

deconcentrated juice just before packing can also

greatly improve taste and product presentation.

LJC has the technical strengths and expertise to pursue this

dynamic marketing strategy which is likely to bring about the

highest possible market penetration. Nevertheless, this can only

be achieved if the company corrects some of its weaknesses

mentioned above.

8 This chart is calculated based on the significance of eachplace of consumption on the total local market and the assumedrelative importance of each consumer type in each market segment.

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The target market

In order to define the target market for LJC the market segments

of consumers which were identified above are further analysed by

the place of consumption as shown in the following chart8:

Under the "me-too" scenario, the company will adopt an

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undifferentiated marketing strategy. However, given the modest

distribution and promotion budget available, LJC will be more

cost-effective in directing its marketing efforts towards market

segments that are more easily accessible. Since the product will

be very similar to existing brands, LJC should compete across the

board with other suppliers. In terms of priority, LJC should aim

at selected mass consumption places (hotels, big supermarkets,

schools, the army etc.) that can more easily be penetrated.

Under the "Offensive" scenario the target market of LJC should be

those consumers who are likely to best appreciate the value of

the better quality product that will be marketed. Within this

cluster of potential customers, the company should aim to

penetrate and expand the local consumption at home by adults

(middle to upper income class families) and at selected hotels

that seek ways to upgrade their image and differentiate their

tourist product.

V. TECHNOLOGY AND PROJECT COSTS

The "me-too" scenario (same product - new package strategy) and

the "offensive" scenario (new product - new package strategy)

will be appraised for financial and economic return. The two

scenarios differ only in so far as the latter involves additional

costs and additional benefits. The "offensive" scenario will

entail an extra cost of production in order to achieve a better

quality product and an additional expense in employing a more

9 Marketing effort as used in this text refers to thedistribution, promotion and discount policy of the company.

18

aggressive marketing effort9. In terms of benefits, the offensive

scenario is projected to have higher prices and volume of sales.

Before considering the two alternative projects it is useful to

review the juice making process.

The juice making process

The juice making process which commences from the delivery of

fruit to the factory and ends with the final product (juice

packed in aseptic carton containers) is summarised below:

The juice production process

+)))))))))))), +))))))))))))))), fruit* Juice *juice * Juice * juice ))))>* extraction /)))))>* concentration /)))))))))))))), * * * *concentrate * .))))))))))))- .)))))))))))))))- * *+))))))))))))))))))))))))))))))))))))))))))))))))))))))))-* +)))))))))))))), +)))))))))))))))),* * Refrigerated * juice * Juice * juice.)))>* storage /)))))))))))>* reconstitution /))))))), * *concentrate * * * .))))))))))))))- .))))))))))))))))- * *+)))))))))))))))))))))))))))))))))))))))))))))))))))))))))-* +)))))))))))))), +)))))))))))), +)))))))))))),* * * * Aseptic * * ** * Juice * juice * filling & * final * Storage & *.))>*pasteurisation/))))))>* packing /))))))>*distribution* * * * *product* * .))))))))))))))- .))))))))))))- .))))))))))))-

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Juice extraction

- Fruit is delivered at the factory premises in truck loads.

Most of the year's supplies are delivered within a period of

four months between February and April.

- The fruit is washed and any spoiled fruit removed.

- Fruit is transferred to the juice extraction machine where

it is automatically cut in half and squeezed to extract the

juice.

- Juice is filtered and piped into an evaporator where it is

concentrated and placed in drums.

- Concentrated juice is placed in cold storage awaiting the

next production stages. Concentrated juice can keep in good

condition for at least a year if refrigerated.

Juice packing

- Concentrated juice is restored to its original consistency

by the addition of water.

- Juice is pasteurised through flash heating under pressure at

a temperature of 85 degrees Celsius for a few seconds. It is

then rapidly cooled to room temperature. The pasteurisation

process renders enzymes present in the juice inactive and

kills harmful micro-organisms.

- Pasteurised juice is piped into the filling machine where it

is fed under aseptic conditions into "brick" shaped carton

containers in 0,25 litre and 1 litre sizes. The packaging

material is a laminate of paper, polyethylene plastic and

20

aluminium providing an effective barrier to micro-organisms,

air and light.

- The containers are then transferred into the packing machine

where they are packed into carton pallets or other

distribution units.

- The pallets are stored in the warehouse awaiting

distribution. The juice packed in this way keeps for several

months at room temperature with its flavour and quality

maintained.

The above process differs only slightly under the "offensive"

scenario. The basic differences are the following:

- During the juice extraction stage, the fruit fibers instead

of being discarded are collected and graded so that they can

later be injected to the juice.

- The juice is concentrated at lower levels than the standard

process so that its flavour is not affected as much.

- During the filling process the fruit fibers are pasteurised

in special equipment and injected into the juice during

filling. The quantity of pulp constitutes 10% of the total

volume of the final product.

It should be noted that under both scenarios the requirement in

fruit juice will only be partly be met (50%) form local

production of juice concentrate. This is because there are

10 The oranges used for juice extraction are classified as"second grade". Their quality in terms of flavour is the same asfirst grade oranges. The difference is in the price (they arecheaper), appearance and size (non uniform shape, irregularsurface etc.).

21

insufficient quantities of suitable grade oranges10 to satisfy

all the producers of juice and because imported concentrate is

normally cheaper than locally produced concentrate. This issue is

discussed in more detail in the Economic Evaluation section.

In terms of capital investment requirements and operating

expenses, the two project strategies compare as shown in the

table below:

22

Comparative investment/cost profiles

"Offensive" Strategy "Me too" strategy+)))))))))))0))))))))))))))))))))))))))))0)))))))))))))))))))))),*Cost *Capital Operating *Capital Operating **Categories *Requirements Expenses *Requirements Expenses */)))))))))))3))))))))))))))))))))))))))))3))))))))))))))))))))))1*Product *Pulp Higher *No Normal **related *separation electricity *investment expenses ** *equipment and fuel cost * ** * * ** *Special Higher * ** *pasteurising production * ** *and dosing labour cost * ** *unit * ** * * ** *Additional * ** *cold room * ** *capacity * */)))))))))))3))))))))))))))))))))))))))))3))))))))))))))))))))))1*Packaging *Aseptic Aseptic *Aceptic Aseptic ** *carton carton with *carton carton with** *packaging high quality *packaging flexo- ** *machinery photographic *machinery graphic ** *capable of printing *liquid (4-colour) ** *handling *juice printing ** *liquids *only ** *and fruit * ** *fibers * */)))))))))))3))))))))))))))))))))))))))))3))))))))))))))))))))))1*Other *Purchase Additional *No Modest **marketing *of sales salaries for *investment promotional**effort *cars and sales * budget ** *fork lift supervisors * ** *trucks & sales depot * ** * personnel * ** * * ** * Cost of * ** * renting five * ** * sales depots * ** * * ** * Substantial * ** * promotional * ** * budget * ** * * *.)))))))))))2))))))))))))))))))))))))))))2))))))))))))))))))))))-

The level of investment required under the two alternative

scenarios is as follows:

11 All values in this report are given in Cyprus Pounds(CP). The exchange rate currently stands at US$ 1.00 = CP 0.48

12 Existing assets are included at their opportunity cost.

13 Working capital is calculated in the projected cash flowsaccording to sales/production volumes for every projected year.The figures given in the project cost are an estimate of thetotal working capital requirement over the first two operationalyears.

23

Investment cost profiles11

CP 000's

"Offensive" "Me-too" Strategy Strategy ---------- ----------

Existing Assets12

Land 30.0 30.0Buildings 70.0 70.0Machinery 200.0 200.0Vehicles 15.0 15.0Working Capital 40.5 40.5

------- -------Total 355.5 355.5

Additional Investment RequirementsPulp separation equipment (CIF) 15.0 -Pulp pasteurising and dosing unit 12.0 -Aseptic carton packaging machinery 305.0 300.0Tariffs (4% of CIF value) 13.3 12.0Installation expenses 35.0 32.0Modifications to buildings 12.0 3.0Cold rooms 30.0 -Sales vehicles (5 x CP5000) 25.0 -Fork lifts (5 x CP5000) 25.0 -Depot office equipment (5 x CP1000) 5.0 -Working Capital13 195.0 115.0 ---------- ---------Total 672.3 471.0 ---------- ---------Total Investment 1027.8 826.5 ========== =========

Working capital in this industry basically consists of raw

24

material stocks (juice concentrate, packaging etc.), finished

goods stocks, accounts receivable and accounts payable. Working

capital requirements are large because of the substantial stocks

of raw materials that have to be kept. This need arises because

all the year's local juice concentrate has to be extracted during

the orange crop season (approximately four months) and placed in

refrigerated storage for subsequent use. The long lead times of

sourcing the foreign concentrate (normally imported from Brazil)

also dictate that significant stocks of imported concentrate must

also be kept.

The total project cost is proposed to be financed as follows:

Financial plan

CP 000's

"Offensive" "Me-too" Strategy Strategy ---------- ----------

Owner's contribution 315.0 315.0Medium term loan 477.3 356.0Existing overdraft facility 40.5 40.5Additional overdraft facility 195.0 115.0 ---------- ---------- 1027.8 826.5

The medium term loan is intended to finance fixed investments

while the additional overdraft facility will finance the

increasing working capital requirements of the project. The

owners will contribute the existing fixed assets which are valued

at their opportunity cost. The overdraft facility of CP 40,500 is

financing existing working capital.

25

VI. PROJECTED MARKET PERFORMANCE

Sales are projected as percentage market share on the total

market size for both the local market and exports. The assumed

project competitiveness affects both the existing market size and

the share of the total market that may be considered attainable

by the project.

Adjusted market size

In the "me-too" scenario it is assumed that the project will

not expand the market because it will compete with a very

similar product as the rest of the industry. The project

will not, by itself, introduce an added market

competitiveness. Nevertheless some of the sales achieved

will be incremental (see Economic Evaluation, below) because

in entering the market, the project will cause a lowering of

the existing market price level. In the "offensive" scenario

the project will create its own demand by supplying the

market with a new product. The impact of this product

differentiation on the existing market is assumed to be

about 5 % of total market size (in volume).

Market share

Under the "me-too" scenario and given that the company is

the third market entrant, with the distinct possibility of a

14 A major carbonated drinks bottler was seriouslyconsidering entering the market.

26

fourth following in the near future14, its market share is

projected to rise slowly (at a decreasing rate) from 10% of

the market in year 1, to 25% in year 10.

Under the "offensive" scenario the project is assumed to

directly benefit from the expansion (5% per cent of existing

market) it induces in the market. Taking this into account

and considering the expected sustainability of the added

market competitiveness of the project over its life, LJC's

share is projected to climb from 12% of the market in year 1

to 37% of the market in year 10.

Market prices

Market prices for the local market were assumed to grow with the

general inflation rate. The base price level of the "offensive"

scenario is projected to be marginally higher to reflect the

higher production costs and the increase in demand emanating from

a superior product performance in the market.

VII. FINANCIAL EVALUATION

The two strategies are evaluated financially by projecting the

cash flows from two different perspectives; the owner's and the

total investment perspective.

15 A comprehensive description of the effects of inflationon the cash flow of a project and a detailed methodology fordealing with inflation in ivestment appraisal is given in GlennP. Jenkins, "Inflation and Cost-Benefit Analysis", HarvardInstitute for International Development, Discussion paper 45,1978.

27

The owner's cash flow statements are first developed in nominal

terms in order to capture all the effects of inflation on the

cash profile of the project15. Nominal cash flows are also

necessary in order to establish the amount that the owners have

to contribute to the financing of the project and whether the

project can repay its loans.

Following the preparation of the nominal cash flow statement, the

constant price level pro-forma cash flow is prepared by deflating

nominal cash flows to their real values. The Net Present Value

(NPV) from the point of view of the owners is subsequently

calculated by discounting the net cash flow by the real private

opportunity cost of equity funds.

Similarly, the proforma cash flow statement from the total

investment perspective is prepared in real terms. All inputs to

the cash flow statement are the same to that of the owner's cash

flow except that loans (principal and interest) are excluded from

both the inflow and outflow sides of the pro-forma cash flow. The

net cash flow line is discounted by the real private opportunity

cost of capital to obtain the NPV from the total investment

perspective.

28

Given no budget constraints, the net present value rule dictates

that the strategy to be selected would be the one that generates

the highest NPV (ie the highest wealth) to the stakeholders of

the company.

Owner's Perspective

The tables below show extracts of the owner's nominal pro-forma

cash flow statements for the two alternatives examined; the "me-

too" and "offensive" strategies. The notes at the end of this

section give the major assumptions used in arriving at the

projected results.

"ME-TOO" STRATEGY

TABLE 1

PRO-FORMA CASH FLOW STATEMENT - OWNER'S PERSPECTIVE

Nominal Values CP 000's ---------- Years ------------ INFLOWS 0 1 2 3 ... 10 11 ------- ================================ Local sales 308 497 640 1486 Export sales 32 48 58 120 -------------------------------- Total sales 340 545 699 1606

Loans 356 Overdraft facility 41 55 30

In use values: Land 51 Buildings 74 Machinery 295 Vehicles 0 -------------------------------- Total Inflows 397 395 575 699 1606 420 --------------------------------

29

TABLE 1 (continued)

---------- Years ------------ OUTFLOWS 0 1 2 3 ... 10 11 -------- ================================ Investments: Land 30 Existing buildings 70 Existing machinery 200 Existing vehicles 15 New buildings 12 New machinery 344 New vehicles

Operating Expenses: Concentrate -local 43 61 76 190 Concentrate -imported 30 48 62 143 Additives 14 22 28 61 Packaging materials 52 83 106 239 Labour Production 14 15 16 25 Administrative 28 30 32 51 Sales 18 19 21 33 Electricity & Fuel 3 4 4 7 Repairs & Maintenance 10 11 11 16 Advertising 17 20 22 33 Sales promotion 2 1 1 1 Distribution 61 98 126 289 Administration 8 9 9 13 Depot rental Taxation 222 Working capital (change): Accounts receivable 20 23 26 19 17 -201 Accounts payable -3 -6 -5 -4 -4 44 Cash reserve 23 44 35 27 26 -300 Loan/overdraft repayments Interest 36 41 38 Principal 59 106 -------------------------------- Total Outflows 712 395 575 699 1363 -457 --------------------------------

Net Cash Flow -315 0 0 0 243 877 ================================

30

The negative sign in the net cash flow line shows the amount that

is being contributed by the owners. Although the intention is to

finance all new investments from medium term loans and an

overdraft facility, the owners in effect contribute to the

project by providing the existing assets (land, buildings,

machinery etc.) which are included in the cash flow at their

opportunity cost. The positive figures in the net cash flow line

show the surpluses that are available to the owners after the

servicing of the loan and the repayment of the overdraft

facility. It can be seen that under the "me-too" strategy, the

company will require a loan amounting to CP 356,000 to finance

fixed investments and an additional overdraft facility during the

first two years of operation to finance increasing working

capital requirements.

31

"OFFENSIVE" STRATEGY

TABLE 2


Nominal Values CP 000's ---------- Years ------------- INFLOWS 0 1 2 3 ... 10 11 ------- ================================= Local sales 427 772 1032 2541 Export sales 45 74 94 205 --------------------------------- Total sales 0 472 846 1126 2746

Loans 477 Overdraft facility 41 83

In use values: Land 51 Buildings 110 Machinery 330 Vehicles 0 --------------------------------- Total Inflows 518 555 846 1126 2746 491 ---------------------------------

32

TABLE 2 (continued)

---------- Years ------------- OUTFLOWS 0 1 2 3 ... 10 11 -------- ================================= Investments: Land 30 Existing buildings 70 Existing machinery 200 Existing vehicles 15 New buildings 42 New machinery 385 New vehicles 50

Operating Expenses: Concentrate -local 52 81 105 282 Concentrate -imported 37 68 90 222 Additives 18 31 41 95 Packaging materials 79 140 186 445 Labour Production 15 16 17 28 Administrative 28 30 32 51 Sales 54 58 62 100 Electricity & Fuel 3 4 5 10 Repairs & Maintenance 10 11 11 16 Advertising 39 45 49 70 Sales promotion 8 7 6 3 Distribution 47 85 113 275 Administration 10 11 11 16 Depot rental 13 13 14 20 Taxation 1 514 Working capital (change): Accounts receivable 20 39 47 35 30 -343 Accounts payable -3 -10 -10 -7 -7 75 Cash reserve 23 66 62 47 45 -491 Loan/overdraft repayment Interest 47 54 46 Principal 95 196 --------------------------------- Total Outflows 833 555 846 1059 2213 -759 ---------------------------------

Net Cash Flow -315 0 0 67 533 1250 =================================

16 The discount rate of 10.5% is the real private opportunity costof equity funds. It is estimated that private investors would requirea 16% nominal return from this type of investment. As the expectedinflation rate is taken to be 5%, the real opportunity cost of fundsis calculated to be:

(16 - 5) / 1.05 = 10.5%

33

Under the "offensive" strategy, the company will require a bigger

loan (CP 477,000) to finance fixed investments. Even though the

cash generation is much higher than under the "me-too" strategy,

the company will also require an overdraft facility to finance

working capital requirements since the larger volume of business

dictates high working capital needs. The net cash flow line

indicates that under the "offensive" strategy the company will be

able to meet all obligations and leave substantial surpluses to

the owners.

All items in the above cash flow statements are deflated to the

base year and the net cash flow line discounted by 10.5%16 to

yield the NPV's of the two different strategies from the point of

view of the owners. The table below shows extracts from the

results:

"ME-TOO" STRATEGY

PRO-FORMA CASH FLOW STATEMENT - OWNER'S PERSPECTIVE Real Values CP 000's ---------- Years ------------ 0 1 2 3 ... 10 11 ================================Net Cash Flow -315 0 0 0 149 513 ================================Discount Rate= 10.5%Net Present Value = 203

17 The real private opportunity cost of capital is aweighted average of the cost of debt and the opportunity cost ofequity funds over the project's life. Assuming that the averagedebt to equity ratio over the project's life to be about 30% debtand 70% equity and given that the cost of debt is 9% and theopportunity cost of equity funds 16%, then the weighted averagecost of capital is:

(0.3 x 9) + (0.7 x 16) = 13.9% nominal or,(13.9 - 5) / 1.05 = 8.5% real.

34



Real Values CP 000's ---------- Years ------------- 0 1 2 3 ... 10 11 =================================Net Cash Flow -315 0 0 58 327 731 =================================Discount Rate= 10.5%Net Present Value = 753

Total Investment Perspective

The tables below show extracts of the net cash flow from the

total investment point of view of the two strategies being

examined. Net cash flows are discounted by the real private

opportunity cost of capital which was computed to be 8.5%17.

"ME-TOO" STRATEGY

PRO-FORMA CASH FLOW STATEMENT - TOTAL INVESTMENT PERSPECTIVE

Real Values CP 000's ---------- Years ------------ 0 1 2 3 ... 10 11 ================================Net Cash Flow -712 -19 64 124 149 513 ================================Discount Rate= 8.5%Net Present Value = 229

35


PRO-FORMA CASH FLOW STATEMENT - TOTAL INVESTMENT PERSPECTIVE

Real Values CP 000's ---------- Years ------------ 0 1 2 3 ... 10 11 ================================Net Cash Flow -833 -35 135 267 327 731 ================================Discount Rate= 8.5%Net Present Value = 843

It can be seen from the above that the "offensive" strategy

yields substantially higher NPV's from both perspectives and

given that there are no budget constraints, it should be

preferred over the "me-too" strategy.

Notes to the Financial Evaluation Section

1. Concentrate (local)

This is a composite cost and comprises of the costs of raw

materials (oranges), labour, electricity and fuel that are

incurred in the extraction and concentration of juice.

Oranges are taken to cost CP 52 per ton delivered to the factory

premises (first operational year). It is anticipated that orange

prices will rise in real terms by 3% per year. In estimating the

volume of juice to be extracted from oranges, it was taken that

1.5 tons of oranges yield 1000 litres of orange juice. Other

direct costs concerned with the production of concentrate are

given in the following paragraphs.

36

2. Concentrate (imported)

It is normally imported from Brazil and is taken to cost CP 600

per ton (first operational year) delivered to the factory

premises.

It was assumed that each operational year's requirement in juice

will be met 50% by locally produced and 50% by imported juice

concentrate.

3. Additives

These comprise of artificial colours, sugar etc and are added to

the fruit drinks. The cost is taken to be CP 0.031 per litre of

fruit drinks produced.

4. Packaging materials

Cost per litre of juice/drink (CP) "Offensive" "Me too"

1 litre containers 0.052 0.0430.25 litre containers 0.077 0.064

5. Labour Costs Number of employees"Offensive" "Me too"

Production - permanent staff 10 9 Production - seasonal staff 12 11 Administration 7 7Sales 15 5

Employee costs are taken to be the same for both scenarios as follows:

37

Monthly cost per employee (CP) Production - permanent staff 210Production - seasonal staff 190 Administration 330 Sales 300

Seasonal staff are employed only during the period of juice

extraction (4 months per year). Payroll costs are assumed to rise

in real terms by 2% per year.

All seasonal staff as well as a proportion of the permanent

production staff are employed for the extraction and

concentration of juice. The cost of this personnel is included in

the cost of locally produced concentrate.

6. Electricity and fuel costs "Offensive" "Me too"

Fixed Cost - CP per year 2000 2000Variable - CP per litre of juice produced 0.0066 0.0060Variable - CP per litre packed 0.0010 0.0010

It is assumed that out of the total cost in this category, 80% is

electricity and 20% fuel. All the variable cost of electricity

and fuel concerned with the extraction of juice and the

production of concentrate is included in the cost of locally

produced concentrate.

7. Repairs and maintenance

This cost is the same for both scenarios and is taken to be

fixed at CP 10000 per year.

38

8. Taxation

The company is liable to three types of taxes: corporate tax,

special contribution and defence levy. In order to calculate the

tax liability, income statements were prepared for the both

scenarios. These statements include interest and depreciation

charges. The depreciation expense is calculated on the historical

cost of depreciable assets using the straight line method.

All provisions of the Cyprus tax law concerning capital and

investment allowances as well as prevailing rates of taxation

were taken into account when arriving at the tax liabilities of

the company.

9. Working capital requirements

The various working capital components are assumed to vary

according to production/sales as follows:

Accounts receivable 1.5 months of year salesAccounts payable 1 month of year's raw materials

It is further assumed that the company will hold such cash

reserves as needed to maintain the normal operation of the

business. It should be noted that only the change from one year

to the next (and not the absolute amount) of each year's

requirements in working capital is entered into the cash flow

analysis.

39

10. Loan and overdraft facility

Interest rates are fixed in Cyprus at 9% per year so both loan

and overdraft facility are assumed to bear this rate. The loan is

assumed to be repaid in five years with one year's grace period

from the date of disbursement. The overdraft facility is assumed

to be repaid according to the availability of surplus cash.

11. Inflation rate

The expected inflation over the life of the company is taken to

be 5% per year.

40

VIII. ECONOMIC EVALUATION

The major difference between the two project scenarios in terms

of economic value stems from the fact that the "offensive"

scenario is projected to expand the market as shown in the

diagram below:

The market expansion is caused by the product differentiation

which is assumed to be achieved under the "offensive" strategy

scenario. This increase in the market is reflected in the diagram

below as an outward shift in the demand for juices.

41

The Demand and Supply of Juices

If the project was to compete at the same level as the rest of

the suppliers in the industry (under the assumption of totally

homogeneous products - "me-too" strategy) quantity and price

would have changed from Qo to Qx and from Po to Px after the

introduction of the project. Displaced quantity supplied would

have been from Qo to Qy. However, because of the product

differentiation achieved by the project, the demand curve shifts

to the right. Hence, the market reaches equilibrium at price P1

18 Although in the "offensive" scenario the sales price ofjuice is higher than in the "me-too" scenario the relevantbenefit from the released resources, is estimated according tothe total economic cost per unit of the displaced suppliers.

42

and quantity Q1. Because of this increase in demand, displaced

quantity supplied is only QoQe.

It is assumed that the saving of the variable cost component

arising from the liberation of economic resources due to the

project, takes place on the same year that the displacement

occurs. However, the saving arising from the release of the fixed

cost component, due to the time necessary to reduce these costs,

is projected to take place with an one year time lag. The total

economic benefit from the released resources (per litre) is

assumed to be equal to the "me-too" scenario sales price (in real

terms) under both the "offensive" and the "me-too" scenario18.

Incremental sales in the "me-too" scenario are equal to QoQx, in

the above diagram, which is the increase in the quantity demanded

and supplied that could be attained without any increase in

demand (Demand - existing producers). This is assumed to be about

50% of the project sales after deducting the market expansion

sales. The incremental sales in the "offensive" scenario are

further increased by an amount equal to the market expansion.

This quantity is depicted by QxQ1 in the above diagram. All

incremental sales are credited with full economic benefits which

are equal to the market price times the quantity sold.

43

The following tables show extracts of the cash flow statements of

the two alternative scenarios from the economy's point of view.

The net cash flows are discounted by the social opportunity cost

of public funds (calculated at 9.5% for Cyprus) to obtain the net

present value to the economy.

"ME-TOO" STRATEGY

TABLE 3

PRO-FORMA CASH FLOW STATEMENT - ECONOMIC PERSPECTIVE

Real Values CP 000's ---------- Years ------------ INFLOWS Conv. 0 1 2 3 ... 10 11 ------- Factors ================================ Incremental sales 147 225 276 456 Release of resources 85 184 244 429 -------------------------------- Total local sales 232 409 520 885 Export sales 1.14 35 49 58 84 -------------------------------- Total sales 267 459 578 969

In use values: Land 1.00 30 Buildings 0.92 40 Machinery 1.09 187 Vehicles 0.68 0 -------------------------------- Total Inflows 0 267 459 578 969 257 --------------------------------

44

TABLE 3 (continued)

---------- Years ------------ OUTFLOWS Conv. 0 1 2 3 ... 10 11 -------- Factors ================================ Investments: Land 1.00 30 Existing buildings 0.92 64 Existing machinery 1.09 218 Existing vehicles 0.68 10 New buildings 0.92 11 New machinery 1.09 375 New vehicles 0.68

Operating Expenses: Concentrate -local 0.94 39 52 62 110 Concentrate -imported 1.09 31 47 58 96 Additives 1.09 14 22 26 41 Packaging materials 1.10 54 82 100 161 Labour Production 1.00 13 13 13 15 Administrative 1.00 26 27 27 32 Sales 1.00 17 17 18 20 Electricity & Fuel 0.91 3 3 3 4 Repairs & Maintenance 1.00 10 10 10 10 Advertising 1.00 16 18 19 20 Sales promotion 1.10 2 1 1 0 Distribution 1.00 58 89 109 178 Administration 1.00 8 8 8 8 Depot rental 1.00 Taxation Working capital (change): Accounts receivable 1.00 20 21 23 17 10 -117 Accounts payable 1.08 -3 -6 -5 -4 -3 28 Cash reserve 1.00 23 42 32 23 16 -176 -------------------------------- Total Outflows 749 348 440 491 718 -265 --------------------------------

Net Cash Flow -749 -81 19 87 251 523 ================================ Economic Discount rate 9.5%

Net Present Value 172 =====

45


TABLE 4

PRO-FORMA CASH FLOW STATEMENT - ECONOMIC PERSPECTIVE

Real Values CP 000's ---------- Years ------------ INFLOWS Conv. 0 1 2 3 ... 10 11 ------- Factors ================================ Incremental sales 284 435 534 880 Release of resources 60 175 274 578 -------------------------------- Total local sales 344 610 808 1459 Export sales 1.14 49 77 93 143 -------------------------------- Total sales 393 687 901 1602

In use values: Land 1.00 30 Buildings 0.92 59 Machinery 1.09 210 Vehicles 0.68 0 -------------------------------- Total Inflows 0 393 687 901 1602 299 --------------------------------

46

TABLE 4 (continued)

---------- Years ------------ OUTFLOWS Conv. 0 1 2 3 ... 10 11 -------- Factors ================================ Investments: Land 1.00 30 Existing buildings 0.92 64 Existing machinery 1.09 218 Existing vehicles 0.68 10 New buildings 0.92 39 New machinery 1.09 420 New vehicles 0.68 34

Operating Expenses: Concentrate -local 0.94 46 69 85 163 Concentrate -imported 1.09 39 67 85 149 Additives 1.09 18 30 38 63 Packaging materials 1.10 82 140 176 300 Labour Production 1.00 14 15 15 17 Administrative 1.00 26 27 27 32 Sales 1.00 51 52 54 61 Electricity & Fuel 0.91 3 3 4 5 Repairs & Maintenance 1.00 10 10 10 10 Advertising 1.00 38 41 42 43 Sales promotion 1.10 9 7 6 2 Distribution 1.00 45 77 97 169 Administration 1.00 10 10 10 10 Depot rental 1.00 12 12 12 12 Taxation Working capital (change): Accounts receivable 1.00 20 37 42 30 18 -201 Accounts payable 1.08 -3 -10 -10 -7 -5 47 Cash reserve 1.00 23 63 56 41 27 -287 -------------------------------- Total Outflows 855 493 648 725 1077 -441 --------------------------------

Net Cash Flow -856 -102 37 174 524 740 ================================ Economic Discount rate 9.5%

Net Present Value 981 =====

It can be seen from the above tables that although both

strategies are projected to yield positive net present values,

the NPV of the "offensive" strategy is substantially higher to

19 Jenkins G. J. and Harberger A. C., Manual on Cost BenefitAnalysis of Investment Decisions, Harvard Institute forInternational Development, Chapter 12, page 3

47

that of the "me-too" scenario. This is primarily because the

project under the "offensive" strategy is projected to expand the

market thus generating greater economic benefits.

The Economic Discount Rate

The discount rate used in the economic analysis was based on the

social opportunity cost of public funds approach, which is a

"weighted average of the marginal productivity of capital in the

private sector and the rate for time preference for consumption

including the cost to the economy from foreign borrowing19". The

economic discount rate was estimated to be 9.5% using data on the

supply and demand of funds in Cyprus as shown below:

20 The economic discount rate is based on 1987 data adjustedfor 3.0% inflation the approximate rate for that year.

21 High income savers were assumed to be those earning anannual salary of over CP 7,000 during 1985. Source: HouseholdIncome and Expenditure survey, The Department of Statistics 1985.

22 The marginal cost of foreign borrowing is arrived at asfollows: MC = AC ( 1 + 1/e)where: MC = Marginal cost of foreign borrowing

AC = Average cost of borrowed funds = 9.5%e = Elasticity of supply of foreign funds = 3.0

48

Inflation Income groups Foreign Qs rate20 High21 Low Govt. Loans--------------------------------------------------------------Supply of funds 100% 3.00% Ws1 Ws2 Ws3 Ws4==============================================================Marginal cost of funds (Ps) 0.080 0.060 0.080 0.126022

Share [S_Share(i)] 69.0% 13.0% 2.0% 16.00%Elasticity of Supply, [Ns(i)] 0.700 0.500 0.000 3.000--------------------------------------------------------------Taxes [T(i)] 0.150 0.000 0.000 0.000Subsidies[K(i)] 0.000 0.000 0.000 0.000==============================================================Weighted Ns(i) 0.483 0.065 0.000 0.4800Weighted Ps(i) 0.037 0.029 0.048 0.0932[Weighted Es(i)*Weighted Ps(i) 0.018 0.002 0.000 0.0447==============================================================

Economic sectors Qd Primary Secondary Tertiary--------------------------------------------------------------Demand for funds 100% Wd1 Wd2 Wd3 ==============================================================Rate of return (Pd) 0.100 0.160 0.180Share [D_Share(i)] 12.0% 15.0% 73.0%Elasticity of Demand [Nd(i)] -1.000 -1.000 -1.000--------------------------------------------------------------Taxes [T(i)] 0.000 0.000 0.000Subsidies [K(i)] 0.140 0.020 0.020==============================================================Weighted Nd(i) -0.120 -0.150 -0.730Weighted Pd(i) 0.056 0.123 0.142[Weighted Nd(i)*Weighted Pd(i) -0.007 -0.018 -0.104--------------------------------------------------------------

Social Opp.Cost of Public Funds [ie] = ([Weighted Es(i)*rs(i)]- [Weighted Nd(i)*rd(i) * Qd/Qs)] / [Es-Nd] * [Qd/Qs]

S.O.C.P.F. [ie] = 9.5%

23 Jenkins G. J. and Harberger A. C., "Manual on CostBenefit Analysis of Investment Decisions", Harvard Institute forInternational Development, Chapter 16.

49

Economic Foreign Exchange Premium

The economic price of foreign exchange (Ee) was estimated as the

ratio of percentage tariffs on imports over the percentage

subsidies on exports weighted by the elasticity in the demand and

supply for foreign exchange23. A five year analysis shows the

economic foreign exchange premium to stabilize at around 14% as

shown below:

(Economic Exchange Price (Ee) / Market Exchange Price (Em))

Variable Year 1 Year 2 Year 3 Year 4 Year 5=================================================================Import Tariffs it 95.8 104.9 105.7 113.9 134.8Imports (C.I.F.) i 796.5 762.3 659.1 711.4 866.8Export Subsidies xk 40.4 42.8 42.9 48.1 56.0Exports (F.O.B.) x 456.3 442.7 437.7 546.7 608.7-----------------------------------------------------------------% Rate of Imports Tariffs Tm 12.03% 13.76% 16.04% 16.01% 15.55%% Rate of Exports Subsidy Kx 8.85% 9.66% 9.79% 8.80% 9.19%Elasticity of Supply Esx 1.00 1.00 1.00 1.00 1.00Elasticity of Demand Edi -1.50 -1.50 -1.50 -1.50 -1.50 Qd/Qs Qd/Qs 1.75 1.72 1.51 1.30 1.42-----------------------------------------------------------------Ee/Em 1.11 1.13 1.14 1.14 1.14=================================================================

Ee = Esx*(1+Kx) - (Edi*Qd/Qs)*(1+Tm) / Esx-Edi*(Qd/Qs)

Ee = 14%

Economic Conversion Factors

In economic evaluation, the financial cash flows are transformed

to reflect their true economic values by multiplying them with

24 These conversion factors were adopted from "The EconomicAnalysis of Projects - CDB Guidelines for Cyprus", a studyprepared by the Cyprus Development Bank.

50

appropriate conversion factors. A few examples on the estimation

of some of the conversion factors used in the economic evaluation

are given below:

Conversion factor for factory buildings

The main components that comprise the financial cost of buildings

are structural steel, cement, bricks, aggregates, labour and the

contractor's profit. The conversion factor for factory buildings

is a weighted average of the respective conversion factors of the

above components.

% of Total Conversion WeightedCost Factor24 Average---------- ---------- --------

Structural steel 30 1.07 32.1Cement 10 0.68 6.8Bricks 7 0.49 3.4Aggregates 5 0.25 1.3Labour 25 1.00 25.0Profit 23 1.00 23.0

-------- -------- 100 91.6

Final conversion factor = 91.6 / 100 = 0.92

Conversion factor for vehicles

Vehicles are imported to Cyprus; their financial price basically

consists of the CIF cost, tariffs and the importer's profit. The

economic price of a vehicle is found as follows:

51

Financial Conversion EconomicPrice Factor Price--------- ---------- --------

CIF Price 2370 1.14 2702Tariffs (70% of CIF) 1660 0 0Profit (41% of CIF) 970 0.7 670

---- ----5000 3381

Final Conversion Factor = 3381 / 5000 = 0.68

The CIF price was adjusted with the foreign exchange premium

(14%) so that the outflow of foreign exchange on the purchase of

vehicles is priced to reflect its opportunity cost.

It is estimated that due to the limited number of motor car

agencies available in the country, importers of motorcars are

making excessive profits in the region of 30% of the total trade

margin. These excessive financial rents are only transfers and do

not constitute an economic cost. The conversion factor for the

importer's profit was therefore set at 0.7.

Conversion factor for machinery

The financial price of machinery basically comprises of the CIF

cost, tariffs and installation expenses. The conversion factor

for machinery is calculated as follows:

25 The adjusted conversion factors were calculated accordingto the following formula:

CF + [(SF x (Ee / Em - 1)]

where: SF = Share of foreign value of goodEe = Economic cost of foreign exchangeEm = Market exchange rate(Ee/Em)-1 = Foreign exchange premium

26 Packing materials are imported directly from the supplierof the filling machines and therefore the trade margin isincluded in the CIF price.

52

Financial Foreign Adj. EconomicPrice CF Content CF25 Price--------- ---- ------- ---- --------

CIF Price 332000 1.0 100% 1.14 378480Tariffs 13280 0 - 0 -Installation expenses 35000 1.0 60% 1.08 37800

------- -------380280 416280

Final conversion factor = 416280 / 380280 = 1.09

Conversion factor for packaging materials

As packaging materials are imported, their financial cost

primarily consists of the CIF cost and tariffs of 4% on the CIF

value26.

The conversion factor therefore becomes:

Financial Foreign Adj. EconomicPrice CF Content CF Price--------- ---- ------- ---- --------

CIF Price 100 1.0 100% 1.14 114Tariffs 4 0 - 0 -

------- ------- 104 114

Final conversion factor = 114 / 104 = 1.10

53

Conversion factor for juice concentrate

Locally produced concentrate

The cost of locally produced concentrate is higher than the

imported one. Typically, the direct production cost of local

concentrate (oranges, labour, electricity and fuel) is higher by

10 - 15% from the cost of imported concentrate. The primary

reason for this deviation is that the government, in an effort to

protect the producers of oranges, allows the importation of juice

concentrate only if the local production of suitable grade

oranges in any particular year is or is anticipated to be

exhausted. So juice manufacturers are obliged to buy locally

produced oranges before they are allowed to import, as the

government links the granting of an import license to purchases

of oranges. There is no fixed rule in determining the amount of

oranges that have to be purchased before a license is given to

import concentrate; the manufacturers have to prove that they

have exhausted all possibilities of securing supplies of oranges

before they are allowed to import.

These government measures resulted in the bidding up of the price

of oranges to levels that make the locally produced concentrate

higher than the imported.

In order to eliminate the distortions caused by the government

restrictions and as juice concentrate can definitely be

classified as tradeable, the economic cost of locally produced

27 This cost was derived from the financial projections andrepresents the real direct production cost of the thirdoperational year. This year is more representative for the wholeprojection period; earlier projection years show a higher per tonproduction cost as the fixed manufacturing costs are spread overa significantly smaller output.

54

concentrate can be taken as the economic cost of imported

concentrate.

Imported juice concentrate

The financial cost of imported concentrate consists of the CIF

cost, tariffs and local transport to factory. The economic

conversion factor is calculated as follows:

Financial Conversion EconomicPrice Factor Price--------- ---------- --------

CIF Cost 575 1.14 655.5Tariffs (4%) 23 0 -Local transport 2 0.75 1.5

------ ------ 600 656.5

Conversion factor of imported concentrate = 656.5 / 600 = 1.09

The conversion factor for local concentrate is therefore

calculated as follows:

Economic price of imported concentrate = 656.5 (see above)Financial cost of local concentrate = 69827

Conversion Factor of local concentrate = 656.5 / 698 = 0.94

The locally produced juices and fruit drinks are essentially non

tradeable goods since the world demand prices (FOB prices) are

lower than the local equilibrium market price. This is primarily

55

because transport costs are prohibitive. Countries that are not

producers of citrus fruit prefer to manufacture their own fruit

juices and drinks from imported concentrate that has a much lower

transportation cost. An exception are the Middle East markets

where currently FOB prices are at least equal or even higher than

the local equilibrium market prices. This phenomenon, however, is

not expected to be sustainable in the long run as these countries

are gradually setting up their own juice packaging plants.

It is interesting to note that juice manufacturing companies are

converting juice concentrate which is a tradeable commodity into

juice and juice drinks which are essentially non tradeable items

due to the substantial increase in the cost of transporting the

final product.

IX. DISTRIBUTIONAL ANALYSIS

A project generates externalities when its financial cash inflows

and outflows differ from their respective economic values. These

externalities are cash flows which are not internalised in the

private accounts and normally comprise the net cash flows to the

government, consumers, labour and other groups in the economy.

The purpose of distributional analysis is to establish who is

gaining or loosing by the presence of the project in the economy.

The steps followed in distributional analysis are:

- Identification of externalities by subtracting the financial

28 The net present value is computed by applying theeconomic discount rate

56

(total investment perspective) cash flows from the economic

cash flows.

- Reduction of each flow of externality into a single figure

by computing the net present value of each stream28.

- Allocation of the externalities to various affected groups

in the economy.

This project generates three types of externalities:

- The first source of externality emanates from the fact that

part of the project's financial revenues are not considered

as incremental to the economy. The economic benefits from

these non-incremental sales are less than the financial

revenues (see Economic Evaluation section) and as a result a

negative externality arises. The meaning of this externality

is that the project is capturing revenues from existing

similar projects in the economy.

- The second source of externality is the difference of the

financial prices of inputs and outputs of the project with

the respective economic ones. This difference is due to

distortions that exist in the market such as price controls,

taxes and subsidies. Economic conversion factors are applied

to adjust the financial cash flows so that they reflect

their true economic values. So whenever each cash flow

stream is multiplied by a conversion factor which is not

57

equal to one, an externality immediately arises.

- The third source of externality is the premium on the

foreign exchange that the project earns from the export of

fruit juices or spends by importing machinery and raw

materials. The divergence between the market exchange rate

and the economic value of foreign exchange as expressed by

the foreign exchange premium is due to the introduction by

the government of tariffs on imports and subsidies on

exports. Therefore the foreign exchange premium earned or

spent by the project represents a net revenue gain or loss

to the government.

Under the "me-too" strategy, the project generates externalities

which amount to CP 5,000 while under the "offensive" strategy

total externalities generated amount to CP 247,000. These

externalities are allocated to the government, other competing

juice manufacturers, producers of oranges and other groups in the

economy as shown in the tables below.

58

DISTRIBUTION OF EXTERNALITIES - "ME-TOO"

TABLE 5

Real values CP 000's ------------------------------------------------------------- Total Govt. Other Producers Other Manuf. of oranges Groups -------------------------------------------------------------

Local sales -220 -220 Export sales 48 48 In use values: Land Buildings -1 2 -3 Machinery 6 6 Vehicles Investments: Land Existing buildings 6 -3 9 Existing machinery -18 -18 Existing vehicles 5 4 1 New buildings 1 1 New machinery -31 -31 New vehicles Operating Expenses: Concentrate -local 28 28 Concentrate -imported -34 -34 Additives -15 -15 Packaging materials -65 -65 Labour Production Administrative Sales Electricity & Fuel 2 2 Repairs & Maintenance Advertising Sales promotion -1 -1 Distribution Administration Depot rental Taxation 293 293 Working capital (change): Accounts receivable Accounts payable 1 1 Cash reserve -------------------------------------- Total Externalities 5 187 -220 28 10 ======================================

59

DISTRIBUTION OF EXTERNALITIES - "OFFENSIVE"

TABLE 6

Real values CP 000's ------------------------------------------------------------- Total Govt. Other Producers Other Manuf. of oranges Groups -------------------------------------------------------------

Local sales -539 -539 Export sales 79 79 In use values: Land Buildings -2 3 -5 Machinery 6 6 Vehicles Investments: Land Existing buildings 6 -3 9 Existing machinery -18 -18 Existing vehicles 5 4 1 New buildings 3 -2 5 New machinery -35 -35 New vehicles 16 13 3 Operating Expenses: Concentrate -local 40 40 Concentrate -imported -51 -51 Additives -22 -22 Packaging materials -116 -116 Labour Production Administrative Sales Electricity & Fuel 3 3 Repairs & Maintenance Advertising Sales promotion -3 -3 Distribution Administration Depot rental Taxation 873 873 Working capital (change): Accounts receivable Accounts payable 2 2 Cash reserve -------------------------------------- Total Externalities 247 730 -539 40 16 ======================================

60

The major beneficiary of the externalities generated by both

scenarios is the government. This is because it receives

substantial revenues from corporate taxes paid by the company.

These revenues outweigh the net revenue loss arising from the

foreign exchange premium. The government stands to gain

CP 730,000 under the "offensive" scenario which is significantly

more than what is projected to gain under the "me-too" strategy

(CP 187,000).

Producers of oranges also benefit from the externalities

generated by the project. This is because they receive higher

prices for the oranges that the project is obliged to purchase

from the local market in order to produce juice concentrate

instead of satisfying all its requirements from imports.

Other competing juice manufacturing companies are expected to

lose by the presence of the project in the economy. Under both

scenarios, the project will capture revenues which could have

otherwise been generated by them.

The reconciliation of distributive analysis at the project level

was calculated by applying the following formula:

NPV(e, re) = NPV(f,rf) + NPV(f,re) - NPV(f,rf) + NPV(ex,re)

where: e = Economic cash flowsf = Financial cash flowsex = Streams of Externalitiesre = Economic discount raterf = Financial discount rate (total investment)

29 The effect of changes to the project cost was not testedbecause this was established with a high degree of accuracythrough the obtaining of firm quotations for most of the projectcomponents.

61

"Me-too" strategy

= 229 + 167 - 229 + 5

= 172 (same as NPV Economy)

"Offensive" strategy

= 843 + 734 - 843 + 247

= 981 (same as NPV Economy)

X. SENSITIVITY ANALYSIS

A sensitivity analysis was carried out to test the impact of

changes in important variables on the project results. The

variables tested were expected market growth, market share, the

rate of inflation, price of imported concentrate, price of

oranges, the proportion of sales that are considered incremental

to the economy and the degree that the project under the

"offensive" strategy expands the market29. A summary of the

results of the sensitivity analysis on the NPV's of the owner,

total investment perspective and the economy is given below:

62

Sensitivity Analysis

"Me-too" scenario Base Test Net Present Value value value Owner Project Economy -----------------------------------Base case results 203 229 172 -----------------------------------Market share - (year 1) 10.0% 7.0% 72 68 -70Market share - (year 2 - 10) 15.0% 10.0% 75 79 -57General inflation rate 5.0% 7.0% 199 200 137Price of imp. concentrate 600 850 119 128 0Price factor - local market 1.0 0.9 52 46 47Market growth factor -local 1.0 0.7 155 172 86Incremental sales ratio 50.0% 30.0% 203 229 81Price of oranges - growth 3.0% 5.0% 180 202 131 -----------------------------------

"Offensive" scenario Base Test Net Present Value value value Owner Project Economy -----------------------------------Base case results 753 843 981 -----------------------------------Market share - (year 1) 7.0% 4.0% 570 630 665Market share - (year 2 - 10) 25.0% 15.0% 399 437 382General inflation rate 5.0% 7.0% 748 806 941Price of imp. concentrate 600 850 626 698 723Price factor - local market 1.0 0.9 480 528 672Market growth factor -local 1.0 0.7 656 731 812Incremental sales ratio 50.0% 30.0% 753 843 761Price of oranges - growth 3

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Juice Company Valuation Jenkins